To Take a Secondary or Not – Now That Is the Question

When a private company is started, its founders are typically issued equity shares that represent their proportional ownership. Over time and for various reasons, a founder may wish to sell some of their stake in the company to other investors via “secondary issue.” Through such an equity sale, an original owner exchanges shares for cash.

In some ways, it’s similar to public equity markets, where any position you hold in a stock is only worth a certain amount “on paper” until you actually sell your shares. With private equity, the value of your investment in a company might be tracked on a platform that manages equity for private companies, but only when you sell shares do you get hard cash in your hands.

In our experience working with many founders, we've often seen people express relief after taking some secondary liquidity by selling shares. We've also heard from folks who wished they had sold a bit earlier. Many founders tell us they feel a strong sense of relief once some of their equity becomes actual cash—liquidity just tends to feel more real than numbers on a cap table.

Our view of how founders are largely open to secondary issues was formed following hundreds of conversations with founders over the past decade. From what we’ve been hearing and observing, the next couple of years appear poised to be highly active for the secondary issue market. We’re not referring to secondaries of $100 million or more (although they could be happening), but seven- or eight-figure secondaries could become more prevalent.

There are several converging and diverging elements (and opinions) at play any time someone is contemplating taking out a secondary. Here’s a sampling. Below are examples of some dynamics, and some that are simply inner monologues masquerading as such:

• “What will my board/investors think?”
• “I’m all-in! I’m not taking chips off the table and giving up all that upside!”
• “What am I going to do with the money anyway?”
• “My company is hot – this may not last forever – might as well cash in on some of my success so far!”
• “I want to buy a place – this will be my down payment.”
• “I haven’t hit my five years yet, so I won’t get QSBS¹ treatment.”

The challenging part of the decision tree is that all of these musings may be true at the same time! We often help founders focus on “why” they are thinking about taking out a secondary. We believe diversification on its own is typically fine (i.e., in our experience, most founders still have 90-95%+ of their net worth in their company equity, even after a healthy secondary), but we think it resonates far more when people find a future purpose and role for this money in their life.

One obvious purpose would be a down payment for a home. This is conceptually interesting, but we always emphasize the need to run the numbers. We often say that the amount you think you can afford, and what a bank thinks you can afford, can be quite different. It’s important to speak with some banks PRIOR to taking a secondary to see if – when taking into account those proceeds – you still fit within their underwriting standards for the price point you’re considering. If not, that’s fine, but at least you won’t be surprised. Often, this helps dictate the amount of secondary to take if you’re tying it back to this specific goal. At Corient, we are here to help you evaluate options available to you.

Another common answer to “why” is the idea of having a capital base that can generate supplemental income to your salary to help elevate your lifestyle. Using a hypothetical scenario, let’s assume that high-yielding money markets are producing a yield of 4% or even marginally higher. That means every $1 million of money in the bank would generate at least $40,000 in passive income.

For illustration purposes using our hypothetical scenario, with money market rates around 4%, $5 million in cash could generate approximately $200,000 annually (or $16,666 per month) in interest income. Of course, actual results will vary depending on prevailing rates and strategy, but you can see how regular cash flow stemming from a secondary issue could make a significant difference in quality of life. Our goal is to support you in understanding the choices you have. When you think about car payments, apartment rents, vacation budgets, etc., those proceeds from secondaries can be meaningful additions to monthly income!

And what about the five-year QSBS holding period before the tax benefits take effect? This one comes up quite often, so it’s important to be aware of something called a “1045 exchange.” ² It may be a way to elongate your holding period, combining your company’s equity as well as equity from another QSBS-eligible company to defer taxable gains. We like putting a derivative twist on a common phrase by saying, “Don’t’ let the tax tail wag the secondary-liquidity dog.” If you want or need some liquidity, consider taking it when it’s available.

And lastly, perception. In general, your investors and board members want you to continue to be “all in.” We think that holding 90-95%+ of your net worth in your company is considered  all-in. Taking some “chips off the table” doesn’t necessarily show a lack of conviction. A knowledgeable advisor can help you discern the various options you have available to live your life as you wish.

Ultimately, taking a secondary is a personal decision. Having helped people with the decision tree hundreds of times, we’ve got the experience to go through the pros/cons of the whys, hows and whats. And remember, not every secondary is created equal. There are many nuances regarding whether or not it’s part of an oversubscribed primary raise, a brokered one-off transaction, etc. Tax nuances. Optics nuances. Matters like that all need to come into play when making your decision.

But again, anecdotally, many founders experience no regret when selling some stock in secondary. Depending on what’s permitted in the deal structure, some founders may choose to take as much liquidity as possible. It’s a personal decision, and we’re here to help evaluate the pros and cons based on your specific goals and circumstances.

¹ https://www.investopedia.com/terms/q/qsbs-qualified-small-business-stock.asp. QSBS refers to qualified small business stock, issued by a qualified small business as defined by the Internal Revenue Code (IRC). There are specific tax benefits to QSBS related to realized capital gains, provided that an individual investor who owns originally issued shares holds these shares for at least five years. Refer to IRC Section 1202 for more information.
² https://www.irs.gov/pub/irs-drop/rp98-48.pdf. Section 1045 of the Internal Revenue Code stipulates that under a certain set of conditions, when a QSBS owner wishes to sell shares that have been held for at least six months and have appreciated in value, they may defer capital gains tax by rolling over their investment to another QSBS within 60 days of the sale (again, provided that certain conditions are satisfied).

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